A time capsule of the greatest financial mania in the history of mankind, told in real-time by regular folks and patriots. May future generations better understand the madness of crowds, and how power and money corrupt.

August 27, 2006

If a homeowner buys a home for $400,000, got it appraised during the silliness for $500,000, takes out a $100,000 HELOC, blows that on say, cocaine and hookers, and now the home is truly worth only $400,000, isn't that HELOC now truly unsecured? And are we about to see massive bankruptcies, commoditized credit write-offs and bank failures?

Roubini:Eight Myths and The Coming Ugliest Housing Bust EverNouriel Roubini has been out front in understanding the current problems in the housing market. He now writes: ".. the housing slump is now undeniable – and rather than a slump it looks like a really ugly bust." In his latest blog post, he details eight myths promoted by those who fail to understand the depth of the housing crisis:

Spin #1: Housing prices are not falling, have never fallen and will not fall

Some folks are still deluding themselves that home prices have not fallen yet and that they will not fall in the future. Indeed, since the Great Depression of the 1930 we have not had a year-on-year fall in median home prices, as opposed to some quarters in which home prices were falling. But now median existing home prices are only 0.9% up relative to a year ago and new home prices are only up 0.3% relative to a year ago. Worse, actual median home prices are falling – on a y-o-y basis - in every US region with the exception of the South. They are even falling in the Mid-West where, allegedly, there was not housing bubble to begin with.

Spin #2: We have never had in US history a recession that was initially triggered by a housing bust. So, it cannot happen this time around

...the effects of the housing bust will be more severe and intense than those of the tech bust because the aggregate demand, wealth and employment effects of housing are much larger than those of the tech sector. So, this will indeed be the first housing-led recession and the second-in-a-row bubble-led recession in six years. Also, as in all the US recessions since 1973, this investment bust – in most cases first in non-residential investment and consumer durables – in this case first in residential investment and consumer durables – will be the combination of three similar factors: 1. shocks that hit investment, be it bubbles or other factors; 2. a monetary tightening; 3. an oil shock. This has been the pattern in every recession since the 1970s and it will be the same pattern in the recession of 2007

.Spin #3: In spite of the housing slump, the levels of activity in the housing market are still very high relative to a few years ago. So, there is now housing bust, only a healthy correction.

These arguments are total nonsense for various reasons:...if an indicator that is at a high level is falling at an annualized rate of 10, 20 or 30% - as many housing indicators are now - there is still a housing bust regardless of the previous level: when first and second derivatives show an accelerating fall, this is a bust and levels may, in due time, go back to the previous lower level of a few years ago.

Spin #4: If the housing bust gets ugly, the Fed will ease rates and rescue us from a recession.

...that the Fed cannot rescue housing and the economy is clear. First, Fed policy in 2001-2004 fed an unsustainable housing bubble in the same way in which the Fed policy in the 1990s fed the tech bubble. Now, like then, it payback time: with huge excess capacity in housing (then in tech capital capacity) even much lower short and long rates will not make much of a difference to housing demand. Real investment fell by 4% of GDP between 2000 and 2004 in spite of the Fed slashing the Fed Funds rate from 6.5% to 1.0%. Does anyone believe or can show that a 50bps or even 100bps easing by the Fed will undo the housing investment bust that is coming in the next two years? No realistic way: when there is a glut of excess supply of capital goods or housing stock or consumer durables, the demand for such durable consumption or investment becomes interest-rate insensitive. When there is a glut of capital goods or consumer durables or housing as there is one now, easing monetary policy becomes ineffective as it is like pushing on the proverbial string.

Spin #5: Credit conditions in the housing market are not tight. Credit growth is still perky and there is no credit crunch. So, unlike the past, there will be no hard landing

Using a core measure of inflation, real rates are not so low for borrowers – even in comparison to conditions in 2000. And for homebuilders now facing falling prices of the goods they are selling – i.e. homes – the real borrowing rate is now extremely high as home prices are now falling. Thus, the reduction in the real price of housing is a severe credit crunch for homebuilders and contractors who are facing a fall in the relative price of what they are selling at a time when there is a glut of new homes: no wonder that building permits housing starts are in free fall (-21% and -13% respectively relative to a year ago).

More importantly, you do not need a credit crunch in order to get an investment bust; if an investment bubble has led to an excess supply of an real asset relative to its fundamental demand, eventually the bursting of such a bubble will lead to a fall in the speculative and fundamental demand for such an asset, regardless of a credit crunch: a modest monetary tightening is enough to burst such a late-stage bubble (a bubble at the late stage when overpricing is so excessive that small shocks are enough to prick the bubble) and trigger a sharp fall in the real investment in such a capital good. The perfect example was 2000-2001 when a 175bps tightening by the Fed between June 1999 and June 2000 was enough to first prick and then burst a tech stock price bubble – that had led to the overinvestment in tech capital goods - and lead to a sharp fall in real investment (by 4% of GDP between 2000 and 2004). The same is happening now with housing: the 425bps tightening by the Fed has finally burst an overinflated housing bubble that was getting out of control with ever rising rate of increase of housing prices.

Spin #6: Given the increase in housing prices there is still so much net wealth (equity) in the housing sector that most households are richer, will keep on feeling richer and will keep on spending more.

...for households with meaningful amounts of untapped home equity, the slowdown and then outright fall in home prices together with higher debt servicing ratios and flat or falling real wages and negative savings, the ability and willingness to further extract home equity will sharply shrink. Indeed, for US households to continue to consume at a rate that is 2% higher than their incomes – as they have done on average since 2005 - implies a significant persistent reduction over time of their remaining home equity; obviously, this Ponzi game of running down one’s own assets to finance an excess of consumption over income cannot go on forever and is not even a optimal path that rational households will take. More rationally, with the housing bust and falling prices, households are been pinched by a negative wealth effect and are starting to cut back on consumption and reduce the rate at which they are dissaving. Indeed, based on the experience of countries such as the UK, Australia and New Zealand, it is enough for home prices inflation to slow down – let alone to outright fall as they are now in the US – for HEW to sharply fall

Spin #7: Banks and mortgage lender are still very sound and there is no risk of systemic banking crisis.

The reality is quite different and much uglier: the housing bubble of the last few years may have planted the seeds of another nasty systemic banking crisis that could be more severe and costly than the S&L crisis of the late 1980s. First, notice that the housing boom of the last few years has led to a credit boom that is quite unprecedented for the US in recent history. Credit boom and excessive overlending episodes – based on cross country experience – often lead to credit busts that cause both banking and financial crises as well as economic recessions...One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs - that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.

Spin #8: Housing may be getting into a slump but such a limited sectoral slump cannot and will not cause a broad economy-wide recession.

...the fall in real residential investment and its effects on aggregate demand will be larger than the 2000-2001 tech bust; the employment effects of the housing bust will be larger than the tech bust as – directly or indirectly – 30% of recent employment growth has been housing-related; the wealth effects of a bust in housing will be large and larger than those of the tech stock bust as homeownership is widespread and housing is a significant fraction of households’ wealth; a housing-related recession can occur if triggered by a housing bubble bursting in the same way in which the bursting of the tech bubble in 2000 led to a recession in 2001; households are now at a tipping point and in a foul mood (as evidenced by the sharply falling consumer confidence level) being buffeted by slumping housing, high and rising oil and energy prices and the delayed effects of rising policy rates while experiencing falling real wages, negative savings and high and rising debt and debt servicing ratios; and Fed attempts to prevent the recessions via a cut in interest rate in the fall or winter will fail to avoid the recession as an unprecedented glut of housing and of consumer durables – starting with cars, home appliances and furniture – will make the demand for housing and durables insensitive to changes in short term and long term interest rates; the housing bust may lead to a banking and financial crisis that may be more acute - and cause a more severe credit crunch – than the S&L crisis of the 1980s and early 1990s that led to the 1990-1991 recession.

We could nit pick some minor differences of opinion we have with Roubini on how the economy works, but for the most part Roubini nails it. But do note that Roubini tends to spend most of his commentary on the recession, downturn side, of the mess created by the Fed. There's another side, price inflation at the consumer level. This economic dragon is a two headed dragon: recession and inflation.

That, Keith is the question of the day. . .although most of my friends took out HELOCS for Granite Countertop Kitchens. My neighbor in NorCal who got an appraisal of 500K, and took out a HELOC for a kitchen, owes more than his place is worth - current units are priced at 439K and aren't sold yet! BTW - the question I have wanted to know - WHAT comes next after Granite Countertops are the Acocado Green Refrigerators (Think Brady Bunch)of the early 21st century? I was at a design center in LA this week and found the answer - frosted glass Italian countertops with lighting from below - kind of glows in dark. . .really neat. In 10 years, people will tear out the dated granite for frosted Italian Glass!

NEW YORK (Fortune) -- For the past five years, the housing bulls have been trotting out one rational-sounding argument after another to explain why the boom made perfect economic sense.

Forget about a crash, they assured homeowners. Expect a "soft landing" where your three-bedroom colonial in Larchmont or Larkspur not only holds onto its huge price gains, but keeps appreciating at a "normal," "sustainable" rate of 6 percent or so into the sunset.

Americans wanted to believe, and they did. Now, the giant popping noise you're hearing is the sound of yesterday's myths exploding like balloons pumped up with too much hot air.

The newest sign that the myth-makers were spectacularly wrong is the data on existing home sales for July. Nationwide, median prices rose .9 percent.

But even that meager number masks the real story. Prices actually fell where housing is most vulnerable, in the bubble markets in the West and Northeast. In the Northeast, they dropped 2.1 percent from July of 2005, at the same time prices nationwide rose around 3 percent, meaning that houses lost over 5 percent of their value adjusted for inflation.

Homeowners just saw their wealth shrink, by a lot. The numbers will only get worse. It's time to examine the clichés that the "experts" - chiefly analysts and economists from realtors and mortgage associations - used to convince Americans that what they're seeing now could never happen. Here are the four great housing myths - and why they never made much sense in the first place.

Myth #1: As long as job growth is strong, prices can't go down

You can almost forgive the bulls for stumbling over this one. In past housing recessions, prices fell sharply in markets with severe job losses, like Texas in the mid-80s and Boston in the early 90s.

But the argument that prices can't fall in a good job market doesn't make economic sense: To be sure, a strong employment picture helps demand. But if far more houses are pouring onto the market than can be absorbed by households lured by the new jobs, and if the sellers are pressured to sell, prices will fall.

That's precisely what's happening now in good job markets such as San Diego and Northern Virginia. In this boom, prices soared to such extraordinary levels that builders kept churning out new homes, and owners of existing houses threw a record number of units on the market to cash out. The supply grew so fast that demand, even in strong job markets, simply couldn't keep up.

As usual, for the believers, it's always easier to fall back on a cliché than read the warning signs.

Myth #2: The builders learned their lesson in the last downturn. They won't swamp the market with new houses when the market turns

You might call this the OPEC theory of homebuilders. The idea was that the builders wouldn't take a chance by building lots of unsold, "spec" units that could clog the market in a downturn. They had supposedly absorbed hard-won discipline from their excessive building in past downturns.

Well, it hasn't turned out that way. Builders are still pouring out near-record numbers of new homes as sales decline, assuring a further fall in prices. "Buyers" are walking away from deposits on houses that were supposedly pre-sold, forcing developers to throw them back on the market at a discount.

The problem is that even now, margins on new homes are still pretty good, though well below the levels of a year ago. As a result, builders will just keep building until those big margins evaporate. High prices are sewing the seeds of their own demise. They always do.

Myth #3: Low interest rates will keep values rising, or at the very least, put a floor under prices

What really matters for all assets, whether it's houses, stocks or bonds, is real interest rates - in other words, nominal rates after subtracting inflation. And real rates fell sharply starting in 2001. That caused a legitimate, one-time increase in housing prices.

The rub is that prices rose far more than could ever be justified by declining mortgage rates. That's where the bubble kicked in. Today's relatively low rates are not, and never were, a reason why prices would keep rising. Once real rates drop and stabilize, the impetus goes away - again, the gain is a one-time, not a recurring, phenomenon.

Today, real 10-year rates are still extremely low. They have nowhere to go but up. When the one-time gain of 2001-2004 reverses, housing prices could take a further hit.

By the way, a decline in rates due to a fall in inflation isn't the boom to real estate it's advertised to be. Sure, rates go down, but workers also receive lower raises. So the fall in rates turns out to be a wash. As for what matters - real rates - what goes down later goes up, and housing prices go in the other direction, namely south.

Myth #4: restriction on development in the suburbs ensure low supply, and guarantee rising prices

This argument ignores that the tough zoning laws and anti-development fervor have been a feature of America's tony towns since the early 1970s. The "not in my town" phenomenon is nothing new.

Sure, it's still difficult to get new building permits in suburbs of New Jersey, New York, Washington, Seattle and San Francisco. But America's housing market is extremely fluid. People move farther from job centers, and commute longer hours, to get bargains where housing is plentiful. Then the jobs move to the areas with the cheap houses. People in their 50s and 60s cash out early in San Diego and buy a bigger house for half the money in Texas or South Carolina.

And the cities are just as enthusiastic about developing blighted areas with new, tax-paying high-rises as the suburbs are slamming the door. In the New York area, Brooklyn, Jersey City and Hoboken - and even Manhattan - are sprouting more new housing than in decades, despite a job market that's hardly robust.

A year ago, the reigning cliché was that real estate had entered a new world of "no supply." Now, a record 3.85 million homes are up for sale, and buyers are getting scarce.

No, the world hasn't changed. And the myths haven't changed either. Next time, don't believe them.

I beleive some of this housing price run-up has come from the REIC convincing people that they are rich. There are an amazing number of people I know out there from friends to co-workers and aquaintances who beleive they are "rich". They are in fact slightly upper middle class or middle class or lower middle class. This run up has foolishly made people beleive that they are the upper 1%. They bought too much, too big, too fast.

Seriously though, what are the prospects for sin trades in the comming depression? If you look at VICEX, you will see that it gotnailed in May too. I guess the excess $$ has lifted all boats equally. I havent checked since the 70's :( but what has the price of coke done durring Bush's tenure? Is it high or is a good buy now? What is its relation ship to the dollar? -El Maha

Is there any way we can pitch in for a few hundred billboards with all the bloggers comments from housing panic?This stuff is not only hallarious,it's all true.The ignorant ,uneducated,sheep need it all"RUBBED IN".BTW I am waiting for housing to drop,and meet rising gold,and will purchase one of the sheeps homes for about an ounce(thats 31.1grams for cocaine/hooker people)

I think the question of the day should be where are all these sellers going to live? You have to live somewhere and you probably won't be living in your car so where do all these sellers plan on going. You would think homes would be a zero sum game. Someone moves from NY to Fl but then another moves from FL to NY. So theres equilibrium in the marketplace. How can everybody be selling at once and to go where? It seems to me we'll still have as many people living in the same houses except many will have lost a bundle from this credit binge ultimately causing them to be poorer through bankruptcies and foreclosures but then getting into a home much cheaper based on realistic lending standards and house prices once again based on values relative to incomes.

On the Fortune article, I stopped reading at this: In the Northeast, they dropped 2.1 percent from July of 2005, at the same time prices nationwide rose around 3 percent, meaning that houses lost over 5 percent of their value adjusted for inflation.

Here's the deal on 100% unsecured HELOC'c. Section 1322(b)(2) of the bankruptcy code says a chapter 13 debtor can modify the rights of holders of secured claims, except claims secured only by the debtor's residence. If there is a "penny's worth of equity," the HELOC lender gets to keep his lien, for whatever it is worth. If the lien is 100% unsecured, the debtor can blow it off in a BK court filing. In a close case, there might be a courtroom battle of the appraisers, but in a Southbound market, some seriously underwater homeowners could squeak through and keep their homes. There are variations on this theme.

Another subplot to our unfolding drama.

BTW, I've always called it the Mortgage Industrial Complex. Free money is responsible for the boom more than any other factor.

You've hit the nail on the head. Others would like to blame the Feds. Truly, it is the mentality of the many who have no regard for the consequences of their actions. Their reckless borrowing founded on greed and impatience drove us to where we are now.

Had we parhaps used that low interest rate then to finance or start up a small business, where the goods can be exported or just simply boost productivity of an existing business, the outcome may have been different. Instead, we've abused the system. It is the easy borrowing and the temptation of spending it in lavish vacations, boats, SUVs, plasma TVs, etc., that doesn't generate a "squat" of revenue.

The Chinese only makes 1/15 of what we make (personal income), but yet they are able to save 30 - 40% of their earnings. Us, we don't save anything. Maybe they don't get to enjoy what we have enjoyed. Wrong, because they are patient, they save and save and then buy (in cash) the same "toys" that we've enjoyed through borrowed money. There's a big difference.

Interesting point. So how does that equate to a foreclosure, whereby there's a difference between what you owe to the bank or lender and the highest bid of your property at auction. Are you still responsible for the difference under the new BK law?

Whitetower, I think you're confusing chapter 13 with chapter 7 BK. There is no income cap for chapter 13. My theoretical underwater debtor would be in BK for three years or more, but he would be able to keep his house if he completed his plan of reorganization.

The HELOC lender would be just another unsecured lender and would have to accept pennies on the dollar, just like a credit card lender.

Consumer bankruptcy hasn't gone away, it is just on vacation. It will be back for all the reasons that people talk about on this blog every day.

"Whitetower, I think you're confusing chapter 13 with chapter 7 BK. There is no income cap for chapter 13."

Oops, I didn't see you specified Chapter 13 previously. But, then, if the debtor does file Chapter 13 the BK court is going to compel him to pay something back -- if not all of the unsecured HELOC debt.

"So how does that equate to a foreclosure, whereby there's a difference between what you owe to the bank or lender and the highest bid of your property at auction. Are you still responsible for the difference under the new BK law?"

Well, it matters exactly what type of bank note the homeowners possesses. If a non-recourse loan (just about all first mortgages are non-recourse in most states), then the homowner won't need to file a BK because the lender can't get a judgment. The lender can take the house, but not income, cars, etc.

So how does the lender recover? It doesn't. Still, the (former) homeowner might be in trouble because the lender can file a 1099 form with the Internal Revenue Service, reporting the amount that the lender couldn't recover at auction as "debt forgiveness," which is treated as a capital gain.

However, if the the loan is recourse, (i.e., a HELOC), then the lender can obtain a civil judgment for what the lender couldn't recover at auction, and attach the homeowner's income, bank accounts, basically anything it can get its hands on.

And, there is no real way to get this judgment discharged (or, if he files prior to judgment, the debt itself) in bankruptcy court unless the former homeowner is without substantial income.

At best, as natural eyebrows pointed out, the former homeowners could file Chapter 13 bankruptcy... and pray that the bankruptcy referee will permit, say, a 70% reduction of the debt.

Thank you very much. I've heard about the debt forgiveness. I've been trying to explain this to some distant relatives, who unfortunately, are in this predicament. It's now clear to me. If I tell them this, I'm afraid they may not be able to sleep or eat. Too bad. They got what they've asked for.

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